The Absolute

Return Letter

January 2024

The Big Questions as We Begin a New Year

“As you go through life, there are thousands of little forks in the road, and there are a few
really big forks – those moments of reckoning, moments of truth.”
Lee Iacocca

Our business model has changed

As some of you will be aware, we have recently changed our business model, following
an approach from a client who encouraged us to invest directly in listed securities on
the back of the same seven megatrends that have formed the backbone of the fund
investments we have made for years.

To cut a long story short, it all resulted in the launch of a new investment vehicle,
which I cannot mention by name in this context, as it is only open to professional
clients as defined by the FCA. If you click here, you can see how the regulator defines
the term “professional client”, and whether you qualify as one. Allow me to provide a
bit of guidance: if you work in the financial industry, zoom in on COBS 3.5.2 (per se
professional clients). If you don’t, zoom in on COBS 3.5.3 (elective professional clients).
That will make it a great deal easier.

The January format going forward

As long-term readers will be aware, for years, I have started the January letter with
Saxo Bank’s (so-called) Outrageous Predictions. Saxo Bank mixes tail-risk forecasting
with a healthy dose of fun; however, our new business model has made me realise it
is time to move on.

Going forward, the January letters will continue to be somewhat different from other
Absolute Return Letters. Overall, they will set the tone for the year to come, i.e. I will
discuss what we, as a team, think will be the most important issues to focus on in the
months to come.

The way it is going to work in practice is that, in December, I will ask the team what
they think are the most important questions/issues to be addressed, assuming a time
horizon of 12 months. I will then seek to answer those questions in the January letter.
This year, four questions stand out:
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January 2024

1. Will 2024 be a good year to invest in risk-assets?

2. What is the outlook for commodities?
3. Will green stocks continue to rebound after having had a tough year?
4. How do you expect equities to react, if interest rates do not come down as
implied by the bond market?

Let’s go straight to the first question.

Q1: Will 2024 be a good year to invest in risk assets?

The short answer to that question is that it depends on the behaviour of the US
consumer. What do I mean by that? Here in Europe, analysts are largely aligned.
Virtually everybody agrees that significant parts of the eurozone are already knocking
on the door to recession. So is the UK, i.e. European financial markets are probably
already discounting one.

In the US, it is very different. Analysts are deeply divided whether the US economy
will go into recession this year or not. Some believe so, whereas others argue a soft
landing is the more likely outcome. I belong in the latter camp, and I do so for two
reasons: (i) the spending power amongst US consumers, who make up 70% of US GDP,
is still significant with meaningful excess savings aggregated in the early stages of the
pandemic (Exhibit 1), and we know Americans love to spend; (ii) the recent increase in
US unemployment is consistent with a soft landing – not a recession. The US labour
market is still too strong (graph not shown here).

Exhibit 1: Excess US savings from the pandemic

Source: Pantheon Macroeconomics

The reason a soft landing in the US is good for risk assets worldwide has to do with
the prominent role of US financial markets. I do not expect more than a modest
correction in European risk assets if US risk assets do well on the back of a soft landing
over there. Having said that, I actually expect Japanese risk assets to outperform both
US and European risk assets, but that is a story I will come back to over the next month
or two.

Q2: What is the outlook for commodities?

To a significant degree, the outlook for commodities depends on whether the
economy is going to go into recession or not. Many (but not all) commodities delivered
poor returns in 2023, very much a function of slowing activities in China. Now, don’t
believe those who argue China is in recession. It is not! Having said that, if you are
used to 7-8% annual GDP growth and suddenly only grow by 3-4%, it feels like one,
and that is where China is today.
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January 2024

If I combine the early signs from China that it has now turned the corner with my
forecast that the US economy should escape the worst in 2024, commodities should
actually do quite well. That said, commodities are many things – energy, industrial
commodities, precious metals and agricultural commodities to name a few, and you
are in danger of over-simplification if you argue that the picture is broadly the same
for them all.

In my book, two types of commodities stand out at present. Firstly, if China has indeed
turned the corner, and if a soft landing, not a full-blown recession, will be the outcome
in the US, industrial metals offer good value at present. Secondly, capex amongst oil
drilling and exploration companies is now less than one-third of what it was a decade
ago (chart not shown). If history repeats itself, lower capex going into drilling and
exploration will, in the foreseeable future, lead to a much lower output. In other words,
demand may be on the decline, but supply may fall even faster, and that should lead
to higher prices.

Q3: Will green stocks continue to rebound after having had a tough
year?
The are many sub-groups of green stocks, but most of them have been through a
dreadful couple of years after hitting new all-time highs in 2021 (+/-). Towards the
end of 2023, most of them started to perform better, though, hence the question –
are the bad times well and truly over?

Let’s begin with the bubble forming in 2019-21. At the time, green stock could do
nothing wrong, and all (green) boats were lifted. Investors paid little attention to the
earnings outlook, i.e. the rally was far too indiscriminate. Suddenly, the tone changed,
as investors began to ask questions, and most green stocks have never fully recovered.

Now, a couple of years later, the outlook for the climate is worse than ever (Exhibit 2),
i.e. the need for solutions is higher than ever. The short-term earnings outlook has not
necessarily improved a great deal (these sorts of things take time), but green stocks
are valued far more attractively today after undergoing a 2-year bear market.

Exhibit 2: CO2 emission cuts required to meet various targets by 2050

Source: IMF

Adding to that, it is indeed possible that the massive challenges that many green
companies, particularly wind turbine manufacturers, have faced over the last couple
of years could reverse in 2024-25. Profits on most green projects turned negative, as
companies were caught out by a combination of significantly higher material costs and
punishing interest rates.
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January 2024

Some of these contracts have now been renegotiated, as it was not in governments’
interest to see these companies go out of business. It is now possible that the new,
renegotiated contracts will be followed by lower material costs and falling interest
rates. i.e. many unprofitable companies could quite possibly turn profitable over the
next few years. (See also Q4 below re unprofitable companies.)

On the back of that, I conclude that, yes, the rebounce should continue. That
conclusion becomes even more affirmative if the economic slowdown in China is now
largely behind us. Having said that, a recession anywhere will dampen demand for
green solutions. Governments have a long and solid track record when it comes to
letting the environment suffer in times of economic hardship.

Q4: How do you expect equities to react, if interest rates do not

come down as implied by the bond market?
Let’s begin with the well-advertised supply chain problems that drove up inflation in
the first place. Supply chain problems worldwide were one of the key reasons inflation
suddenly became a major problem after having been dormant for years. After a few
false starts, inflation finally appeared to be under control again, but then Hamas
attacked and Israel responded in kind. To cut a long story short, it has had a significant
impact on shipping rates through the Red Sea, i.e. it has had an inflationary impact on
most goods shipped between Asia and Europe (Exhibit 3).

Exhibit 3: Drewry Shipping Index

Sources: Gavekal Research, Daily Shot

As I don’t expect the armed conflict in Gaza to end anytime soon, ships passing
through the Red Sea will continue to be at risk for a fair bit longer. The only alternative
route, around Cape of Good Hope at the southern tip of Africa, may be cheaper as far
as insurance is concerned but much more expensive in fuel costs. You may argue that
this is not a US but a European problem. Whilst partially correct, in today’s
interconnected world, and as we learnt during the first supply chain crisis, rising
inflation in one part of the world will quickly affect prices in other parts of the world.

Should this force the Fed to keep interest rates higher for longer, first and foremost,
‘junk’ stocks will be at risk. Allow me to explain. I define ‘junk’ stocks as:

(i) listed tech companies with negative earnings, thus dependent on borrowed
capital to finance the business; and/or
(ii) the most shorted, listed companies.

As you can see in Exhibit 4 below, ’junk’ stocks performed exceedingly well, following
Jerome Powell’s half-promise to lower interest rates at least three times in 2024.
Having said that, as you can also see, unprofitable tech companies had a horrid time
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January 2024

in Q3 as interest rates rose, thus raising the cost of capital, and so did the most shorted
stocks. I assume short covering was a major factor behind them rallying in Q4.

Exhibit 4: 2023 performance of US ‘junk’ stocks

Note: As of the 17th of December 2023
Source: Financial Times

If interest rates have to stay higher for longer, and that is indeed a big “if”, if one takes
Jerome Powell’s recent comments into account, the recent Q4 rally is unsustainable.
Therefore, the answer to the question is that ‘junk’ stocks are most at risk. That said,
just like the ‘junk’ rally lifted all boats, the end of the ‘junk’ rally could sink all boats
again.

Niels C. Jensen
3 January 2024

© Absolute Return Partners LLP 2024. Registered in England No. OC303480. Authorised and Regulated by the
Financial Conduct Authority. Registered Office: 16 Water Lane, Richmond, Surrey, TW9 1TJ, UK
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January 2024

Important Notice
This material has been prepared by Absolute Return Partners LLP (ARP). ARP is authorised and
regulated by the Financial Conduct Authority in the United Kingdom. It is provided for information
purposes, is intended for your use only and does not constitute an invitation or offer to subscribe for
or purchase any of the products or services mentioned. The information provided is not intended to
provide a sufficient basis on which to make an investment decision. Information and opinions
presented in this material have been obtained or derived from sources believed by ARP to be reliable,
but ARP makes no representation as to their accuracy or completeness. ARP accepts no liability for
any loss arising from the use of this material. The results referred to in this document are not a guide
to the future performance of ARP. The value of investments can go down as well as up and the
implementation of the approach described does not guarantee positive performance. Any reference
to potential asset allocation and potential returns do not represent and should not be interpreted as
projections.

Absolute Return Partners

Absolute Return Partners LLP is a London based client-driven, alternative investment boutique. We
provide independent asset management and investment advisory services globally to institutional
investors.

We are a company with a simple mission – delivering superior risk-adjusted returns to our clients. We
believe we can achieve that through our thematic investment philosophy combined with a disciplined
risk management approach.

Our product development, asset allocation and portfolio construction are all driven by the seven
megatrends we have identified. We frequently refer to those megatrends in the Absolute Return
Letter.

We have eliminated all conflicts of interest with our transparent business model, and we offer flexible
solutions, tailored to match specific needs.

We are authorised and regulated by the Financial Conduct Authority in the UK.

Visit www.arpinvestments.com to learn more about us.

Absolute Return Letter contributors:

Niels C. Jensen nj@arpinvestments.com T +44 20 8939 2900

Mark Moloney mm@arpinvestments.com T +44 20 8939 2900

Sina Dolen sd@arpinvestments.com T +44 20 8939 2900